How to Use a 3-Fund Portfolio in Your 401(k)

When it comes to choosing investments for your 401(k), the number of options available can be overwhelming. There are, however, a number of relatively simple investment strategies you can use to get the most out of your 401(k).

One strategy is to invest in a target date fundwhich will automatically optimize your wallet for retirement on a certain date. Another slightly more complicated approach is to build a three-fund portfolio.

With the three-fund approach, you’ll have to do a bit more research to find suitable funds, but you’ll have more control than with a simple target date fund. In this article, we’ll explain what a three-fund portfolio is, how it works, and some of its key benefits.

What is a 3-fund portfolio?

The idea of ​​a three-fund portfolio emphasizes diversificationa fundamental concept of investing.

However, this approach also offers simplicity for average investors managing their 401(k). A three-fund portfolio focuses on three fundamental asset classes: domestic (US) equities, international equities and domestic bonds. The offer of the big brokers mutual fund which provide exposure to each type of asset.

Investors can then determine the best allocation of funds concentrated in each asset class according to their investment horizon. For example, you may have a portfolio that is 90% actions and 10% obligationsor vice versa.

US stocks tend to offer the potential for higher long-term returns, but they also pay more risk. Therefore, younger investors may want to allocate more funds to them.

Advantages and disadvantages of a 3-fund portfolio

When it comes to managing the investments in your 401(k), you may have to compromise between simplicity and control. Although a target date fund requires less effort to make investment decisions, you will lose some freedom in your investment choices. On the other hand, you can carefully research and manage every aspect of your portfolio, choosing individual stocks that you think will increase in value, but are likely to have increased risk.

A portfolio of three funds offers a middle point between these approaches. It offers you most of the diversification of a target date fund, while allowing you to tailor your investments to your needs.

An example of this is your portfolio’s asset allocation. If you are between 20 and 30 years old and put all your 401(k) money in a target date fund tied to your expected retirement age, you can start with 90% of your assets invested in stocks and 10% invested in bonds. By the time you reach 50, the same target maturity fund may have 40% or more invested in bonds, which can reduce your returns just before you reach retirement. By managing your own portfolio, you can manage your own risk.

As with any investment approach, the three-fund portfolio also has drawbacks. By choosing only three asset classes, you are missing out on broader diversification with other types of assets like immovable Where gold. Another downside is that you’ll be responsible for some of the management, like making sure you have the right mix of bonds and stocks. Target date funds, on the other hand, have automated rebalancing.

Build a 3-fund portfolio

If you decide to use a three-fund approach for your 401(k) portfolio, you have two main decisions to make. First, you need to determine your asset allocation ratios. Then you need to choose the exact funds for three basic asset classes.

Asset allocation

Your asset allocation is how you divide your asset types to manage risk and the potential return that suits your goals. With the three-fund approach, you allocate a certain percentage of your portfolio to one of three types of assets: US stocks, international stocks and bonds.

Consider your risk tolerance and your investment horizon when you choose your allocation breakdown. Young investors generally have a higher tolerance for risk because they have a longer investment horizon, which allows them to weather the ups and downs of the market. Therefore, younger investors may want to invest more in aggressive assets like stocks.

Older investors, including those approaching or in retirement, tend to prioritize capital preservation. They may therefore want a higher proportion of low-risk assets, such as bonds, to protect the funds they need for living expenses.

Choose your funds

The final step in building a three-fund portfolio is choosing specific funds. As a general rule, you should look for low-cost, well-diversified funds. All major brokers have funds that represent each of the basic asset types, so you can build a three-fund portfolio through a single broker or spread your investments across multiple brokers.

For example, you can have a portfolio with these three Vanguard mutual funds:

• Vanguard Total Stock Market Index Fund (VTSAX)
• Vanguard Total International Stock Index Fund (VTIAX)
• Vanguard Total Bond Market Index Fund (VBTLX)

You can also use exchange-traded funds (ETFs) invest in asset types. A similar portfolio would include:

• Vanguard Total Stock Market ETF (TIV)
• Vanguard Total International Stock ETF (VXUS)
• Vanguard Total Bond Market ETF (BND)

Shop around to find the funds that suit your needs and consider consulting a financial advisor for advice on aligning your portfolio with your investment goals.

The essential

A three-fund portfolio is a portfolio management approach that focuses on using three funds to invest in three types of assets, typically US stocks, international stocks and bonds. This strategy is popular among the “Boglehead” community, which follows the investment principles championed by Vanguard founder John Bogle.

You can use a three-fund approach in most 401(k) accounts, depending on whether or not your employer offers funds to represent each type of asset. You will need to decide which three funds to use and how they will be distributed in your portfolio.